Sunday, August 24, 2014

Benjamin Cole ends his most recent blog post saying "To get to higher interest rates and inflation, we may have to endure years and years of prosperity. And even that may not work. I think we should try anyway." This is a terrific bit of writing, and will inflame those whom he calls the "righty-tighties".I did, however, take slight issue with his first two comments, namely (a) that tight money is sacred to the right, and (b) that the right always finds monetary policy too loose. That is (deliberately, I'm sure) exaggerated, and thus unfair to the right. The likes of David Beckworth and Ramesh Ponnuru have published numerous times in the National Review in favour of easier monetary policy, as has Jim Pethokoukis at the AEI. Still, Benjamin's jibe raises a valid question: What kind of dollar does that faction of the right want?"Sound money" is often advocated by Internet Austrians, but is a sufficiently imprecise concept as to be unhelpful. In theory, there should be plenty of middle ground between those who desire "sound money" and flexible inflation targeters. However, some common objections to FIT are (1) the Fed's dual mandate is wrong, and should focus solely on inflation; (2) "sound money" demands no inflation (and hence no loss of purchasing power), not the unforgivable 2% inflation that most central banks target, (3) the Fed uses incorrect (and possibly doctored) inflation statistics to hide its inflationary bias, revealed by ShadowStats and other sources, and (4) the only way to ensure sound money is to rid the world of fiat currency.While I won't go through the counter-arguments to these (incorrect, in my opinion) points, it's worth noting that this is an age-old debate. This 1896 paper from Fred M. Taylor, for example, evaluates the merits of an "elastic currency" - language that made it into the Federal Reserve Act of 1913 - defined loosely as "a currency the amount of which varies in accord with the needs of industry." While the terminology is archaic, it is the precursor to the Fed's dual mandate. Taylor seems to conflate the concepts of money and credit in the paper, but he properly distinguishes between ordinary and emergency elasticity, writing "By the former, I mean that elasticity which adapts the amount of the currency to the varying needs of trade within the limits of a single ordinary year. By "emergency elasticity", on the other hand, I mean the capacity of the currency to adjust itself to those fluctuations in the need for money which characterize a panic." The concept of "emergency elasticity" is one that "sound money" types seem to ignore. Taylor notes that at the time of writing, victory belonged to "the advocates of a safe rather an an elastic currency." While the supporters of elasticity are mainstream today, "sound money" proponents seem to yearn for a return to "safety". The costs of this safety, however, surely deserve attention.Equally worth of criticism is the "Strong Dollar" demanded by other righty-tighties. Many "Strong Dollar" types seem to be business people who pride themselves on their practical leanings and material success, and decry the Fed's intervention in the free clearing of a market (unless dollar strength limits their ability to export - there sometimes seem to be fewer true libertarians in business than there are atheists in foxholes!). Alas, these practical types do not seem to realize that they would scoff heartily at fellow producers who decided that their sole goal in business should be a "strong price". Yes, business people seek the strongest price possible, but within the limits of competition. What they truly aim for is the strongest price that customers will bear, and which results in the highest total profit (broadly speaking). To seek a strong price ignoring customers' willingness to pay would be madness. Furthermore, when demand is high for their goods, these producers often increase supply, but criticise the Fed for pursuing a similar course of action (as the Fed should rightly do, when furnishing emergency elasticity, for exampe).No doubt we'll be hearing more from the righty-tighties as the pressure mounts on the FOMC to raise rates. It's even possible that at some point they'll be right. But the rest of us should remind them they've been consistently wrong for the past 7 years. While "sound money" and "strong dollar" policies sound inoffensive at first blush, the faulty thinking underlying them cannot be allowed to infect central banks, who may face pressure from politicians looking to score points. We've seen how that's played out in Europe, and to allow such thinking to fester anywhere else is an invitation for trouble.

Sunday, August 17, 2014

Twitter's excellent Sober Look pointed me towards the WHO's disconcerting warning that the current Ebola outbreak has been underestimated. The WHO believes that the number of reported cases and deaths is being underestimated, as is the time expected to fully contain the outbreak. This caught my eye because I had earlier insisted on Twitter that news consumers were overplaying the risks of Ebola, while ignoring the potential significance of China's hukou reforms in improving the social and economic lives of millions of people. I don't know if the Ebola outbreak is cause for concern for those outside of West Africa, especially as other commentators like Dan Drezner decry Ebola scaremongering, but I was reminded of another time when I was wrong in assessing the risk of a situation, i.e. evaluating the economy and financial markets in 2007-08.

Seven years after the onset of the Great Recession, there are many competing theories about what happened to produce such a financial and economic catastrophe. I wrote a post praising Ed Catmull's "Creativity, Inc." last week, and this quote stood out to me, among other gems: "Hindsight is not 20/20. Not even close. Our view of the past, in fact, is hardly clearer than our view of the future. While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited. Not only that, because we think we what happened clearly - hindsight being 20/20 and all - we often aren't open to knowing more." I won't even attempt to rehash the arguments, but will merely state my view that financial fragility caused by high leverage, poorly understood products and contagion effects interacted with some pernicious monetary policy decisions to create the crisis. Despite my deep interest in prior financial panics, I believed that the subprime debacle in the US would be contained, leading to a recession but not the mini-Depression that ensued. Suffice to say I was wrong. I had an insufficient appreciation for the hidden leverage throughout the financial system and the potential for contagion. I also failed to foresee that major central banks were allowing monetary conditions to tighten like a vise around their economies.

I'll let myself off the hook slightly by conceding that it is the very nature of complex adaptive systems that leads to such surprising outcomes. Furthermore, I'm certainly not saying that this Ebola outbreak is the health equivalent of 2007-2008. I'm merely recognizing that there is more to be worried about when contagion is involved. This is in contrast with that other recent favourite of scaremongering journalists, the spate of air crashes worldwide. While I view the air crashes as largely independent and random events, the contagion characteristics of an epidemic offer greater cause for concern.

So what would have been the appropriate response in 2007-2008? This is a more difficult question than it seems. As Kissinger says in his book "On China", "Analysis depends on interpretation; judgments differ as to what constitutes a fact, even more about its significance." An omniscient trading genius would have been heavily short by May 2008, and would have reversed course in Mar 2009. This is highly unrealistic, and much easier said than done, since anyone smart (or nervous) enough to have sold in May 2008 would likely have had an aversion to re-entering the market even when it was cheap (relative to fundamentals) in middle to late 2009. The hardy few will suggest that the best path would have been to do absolutely nothing. After all, if Lehman's bankruptcy had put you in Rip Van Winkle state on 16 Sep 2008, you could have woken up on Apr 23, 2010 to find the S&P 500 unchanged at 1213. Of course, this ignores the opportunity cost of maintaining your holdings - you could have sold on 16 Sep and had the opportunity to buy at lower levels.

Thankfully we have two tools that can aid us in this difficult task, namely (a) valuation and (b) scenario analysis. Valuation provides an anchor while the investor is buffeted by waves of events and information. Scenario analysis allows us to consider various possibilities and incorporate them into our valuation. Both have to be subject to rigorous scrutiny, because "valuation" can ossify into dogma, ignoring changing facts and the multitude of assumptions under the surface of purported precision. I suspect using these two tools in 2007-2008 would have led an investor to be less long (it takes a different mindset to short successfully), and would have allowed the investor to gradually increase his exposure throughout 2009 (and indeed, through 2013, when I think stocks went from being cheap to being fairly priced).

These are not easy judgments to make, and this, after all, is why truly talented investors deserve to be compensated accordingly. Combining the relevant financial analysis with a subtle appreciation of the sociology of markets requires an unusual calibre of investor. If you find that person, I suggest you hold on to her - and suggest equally that you prevent her from undertaking any non-essential travel to the affected West African countries until we better understand the extent of this outbreak.

Sunday, August 10, 2014

I rarely delve into the genre best described as "General Management" since I quickly get annoyed with formulaic nostrums for success and the lionization of specific business leaders, particularly where they appear to have been lucky rather than good. But I'd heard so much positive press about Ed Catmull's "Creativity, Inc." that I decided to dip my toe in just this once. I'm grateful that I did, because Catmull's book is extremely atypical of the genre. Catmull is one of the co-founders of Pixar, and the current President of Pixar, Disney Animation and DisneyToon. He offers a fascinating look at Pixar's history, including its many challenges throughout its history. Steve Jobs fans will find the book worthwhile simply for the anecdotes about him, and an afterword describing his contribution to Pixar. But even more importantly, I think the book has lessons for those outside what we traditionally see as "creative" industries. It won't surprise friends and long-time readers that I think of investing as a creative enterprise to a large degree (note that I said "investing" rather than "finance", since I don't think loan officers, for example, should be too creative in their professional lives - we know how that ends!). That said, I do think that even those who are unambiguously outside the "creative" world (e.g. commercial bankers) can learn a lot about creating strong and flexible organizations from Catmull's deep insights into these issues (as I summarize in the third paragraph).I imagine there are many people who will take issue with my suggestion that investing should be creative. For some, "creative" investing has the whiff of Madoff-style deception, or Victor Niederhoffer-style volatility. For others, investing is best pursued by mechanical rules, either through index funds, dollar-cost averaging or algorithms tied to valuations. It is difficult to refute each of these individually, and I have a fair amount of sympathy for those who eschew active management at all costs. And it seems that active managers have understood their customers well, realizing that career longevity is tied to avoiding underperformance, rather than maximizing long-term performance, as Porter and Trifts have shown. Nonetheless, I maintain that that rare breed of manager - the alpha generator - must be creative in generating ideas, skilled in adapting to the complex currents of economies and markets, and humble in the face of mistakes. Robert Hagstrom was spot-on when he brilliantly described investing as the "last liberal art", and Catmull echoes this in his book when he writes, "Craft is what we are expected to know; art is the unexpected use of our craft."Catmull's book touches on many themes close to my heart - uncertainty, randomness, and social dynamics, among others. It is difficult to capture his lessons adequately without the resonance of his anecdotes about Pixar. Nevertheless, here are some of the broader lessons that are applicable to creating strong, loosely "creative" organizations:- Make a policy of hiring people smarter than you are, no matter how threatening it may seem as a manager. An organization that is committed to seniority is doomed to mediocrity.- "If you give a good idea to a mediocre team, they'll screw it up. If you give a mediocre idea to a brilliant team, they will either fix it or throw it away and come up with something better. Getting the right people and the right chemistry is more important than getting the right idea."- Create organizations where people are encouraged to - and see it as their duty to - communicate problems and offer solutions. Many problems lie hidden from the view of management. - Candid and bracing (but constructive) feedback and the iterative process allows creativity to be channelled into an end product. "You are not your ideas, and if you identify too closely with your ideas, you will take offense when they are challenged."- "Mistakes aren't a necessary evil. They aren't evil at all. They are an inevitable consequence of doing something new (and, as such, should be seen as valuable; without them we'd have no originality)."- Leaders should talk about their mistakes to make it safe for others to follow suit. - "While we don't want too many failures, we must think of the cost of failure as an investment in the future."- "The antidote to fear is trust...Trusting others doesn't mean that they won't make mistakes. It means that if they do (or if you do), you trust that they will act to help solve it."- "Management's job is not to prevent risk but to build the ability to recover."- "When someone hatches an original idea, it may be ungainly and poorly defined, but it is also the opposite of established and entrenched - and that is precisely what is most exciting about it."- "In an unhealthy culture, each group believes that if their objectives trump the goals of the other groups, the company will be better off. In a healthy culture, all constituencies recognize the importance of balancing competing desires - they want to be heard, but they don't have to win."- "Randomness is not just inevitable; it is part of the beauty of life. Acknowledging it and appreciating it helps us respond constructively when we are surprised."- "Those with superior talent and the ability to marshal the energies of others have learned from experience that there is a sweet spot between the known and the unknown where originality happens; the key is to be able to linger without panicking."- Hindsight is not 20-20. "While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited", so we must be cautious about drawing generalized lessons from events.- Creativity is "unexpected connections between unrelated concepts or ideas", and we need to be in a certain mindset to make those connections. - "Our specialized skills and mental models are challenged when we integrate with people who are different."- "Measure what you can, evaluate what you can measure, and appreciate that you cannot measure the vast majority of what you do."As I re-read this, I realize there is the danger of this coming across as a bunch of management-speak platitudes, but I urge you again to read the book for yourself and mull over a book that I hope to return to many times in the future.